The Hll Enigma

With a spectacular performance for 1997, HLL continues on a consolidation spree with its acquisition of Lakmes brands and the proposed merger with Ponds.

What does it mean for investors?

When nothing, but nothing seemed to be happening in the markets, Hindustan Lever's announcement last week of phenomenal results and its intention to merge Ponds and buy out Lakme brands shook the market out of a seemingly terminal ennui. The scrip shot up to Rs 1526, gaining Rs 143 within a matter of a week. Historically a good hedge stock, Hindustan Lever (HLL) has been trading at a premium of 2.5 times the market. With the current spurt in prices, it seems to have outdone itself and is trading at 4 times the market.

 

Yet, analysts are unanimous that even at these levels HLL makes a good buy for an investor with a 1-2 year investment horizon. Sandeep Bhatia, associate director-research, UBS Securities, expects the scrip to appreciate by 20-25 per cent by the end of the year. The Smart Investor therefore looks at this rare animal called HLL to understand the reasons for the optimism.

The story so far

A strong 35 per cent growth in net profits (excluding extraordinary items) on the back of a solid 18 per cent growth in turnover. Leading the topline growth was the personal products division (47 per cent), the fastest growing division of HLL. This growth was made possible by a concerted effort at innovation 44 brand launches including 23 relaunches.

Historically, HLL's dominance in the soaps and detergents markets ensured stable bottomline growth. This year in spite of the beverages and foods businesses exerting a pressure on margins, operating profit margin rose by 80 basis points. This even after the company nearly doubled its ad-spend to Rs 450 crore and had to absorb the impact around Rs 80 crores of the change in basis of excise duty levy to pack printed price. Tight control over working capital which saw interest costs falling 41 per cent over previous year further contributed to bottomline growth.

HLL's results have made every sceptic who had predicted pressure on margins and growth because of investments in ice cream, foods and beverages eat humble pie. How was HLL able to pull off this coup especially in an industry which witnesses some of the bitterest marketing battles for every Coke there is a Pepsi and for every Surf there is a Nirma? And how does it keep extending the optimum point on the economies of scale curve? Mainly because of the strong competitive advantage HLL derives from its very superior marketing skills and extensive distribution network, says Bhatia. Also the skill of very tight fund management says another analyst.

Core competencies

HLL's marketing skills, often termed as machiavellian by competitors, have produced many a winner. In an industry where brand loyalties are extremely fragile, mere availability is an immense advantage. HLL has developed a very wide distribution network of 6,800 distribution stockists which covers the entire urban population and all villages with over 2,000 people. Nearly one million of the 4.2 million retail outlets in India are

covered directly. In fact, it is this focus on the rural market which gives HLL its volume growth.

HLL's funds management has made corporate history. The company is able to get good terms from both its suppliers and creditors -- its 'creditors' make advance payments. HLL's ability to operate on a very short trade cycle has been a major contributor to improving margins. Proactive treasury management also contributes to low costs. This tight funds management is made possible by a very advanced satellite based communication system, the first such network to be set up a consumer goods company in India. The network links over 200 locations, including the Head Office, branch offices, factories, depots and key distribution stockists.

In spite of being a marketing driven company, HLL has the technical capability to design and manufacture machines in-house or have them assembled by third party as per given specifications. Consequently, HLL has been able to increase capacities at half the cost of competitors.

The other factors that make HLL the showpiece are its management depth and an emphasis on value addition which is possible by extensive research. At any point in time, its research department is said to be working on over 40 product ideas. HLL is said to have the quickest response time to any threat. A rich parent with a focus on India also helps.

In order to gain an insight into HLL's future growth prospects, one has to trace its growth and study the growth potential of its present businesses. HLL's growth strategy has been driven by a commitment to double its turnover every four years and PAT every three years. Thus when its traditional business of soaps and detergents entered the maturity phase, it went on a shopping spree to buy businesses which would give it growth in the future, while also extending the life of its present businesses. Guiding the purchases was parent Unilever's thrust areas, ie foods, personal products, detergents and speciality chemicals. Thus Tomco, Brooke Bond-Lipton, Ponds and Lakme came about. To its credit, HLL has been able to amply reward shareholders of the 'taken over' companies.

Diversified portfolio

HLL now has a presence in the personal care business (soaps, shampoos and toothpaste), soaps and detergents, beverages (tea and coffee) speciality chemicals and foods.

Personal soaps is a cash cow for HLL. The Rs 4,000 crore (450,000 tonne) industry is dominated entirely by HLL. Near complete penetration of the market has been achieved. While HLL may be able to sustain its present rate of growth of about 13-15 per cent in the segment for the next few years, growth then on would taper down to the industry growth of 5-6 per cent. HLL is currently milking this cash cow.

HLL is a market leader of the 2-million tonne synthetic detergents market. A low market penetration makes this a very lucrative segment for HLL. A cash cow for HLL, this segment is expected to lend to future topline growth of 18 per cent.

The personal products business (shampoos, toothpaste, toothbrushes and skin care) is the fastest growing business for HLL and 'will be at the helm of HLL's future growth'. HLL is a dominant player in this market also whose size it estimated Rs 2,226 crore. Analysts estimates a growth of 30 per cent from this segment.

Prime facie, it might seem that beverages for HLL is not such a good idea since at present there is little backward integration because it does not own enough plantations compared to its competitors like Tata Tea, exposing the business to price fluctuations. But because of the huge labour involvement in tea gardens, backward integration is not necessarily a good idea.

The total beverages market is estimated to be in the range of 600 million kg. In fact, HLL's tea business is more profitable than Tata Tea's business. What makes this business worth investing in for HLL is the relatively low market penetration. Whether HLL is able to do the same to its beverages business that it did to its personal care business in the eighties is yet to be seen. Analysts expect a topline growth of 15 per cent from this division.

HLL has so far invested about Rs 300 crores in its ice cream business which is yet to break even. The ice cream market in India is estimated at more than Rs 300 crores. In a business where transportation over long distances is not possible, HLL has a presence in all parts of the country through its acquisitions. Future growth would come only if HLL is able to increase the market by investing further in the cold chain.

The speciality chemicals business is small and is not a thrust area. It is however globally competitive on both quality and cost parameters. Unilever has sold off its speciality chemicals business for a consideration of $4.7 billion. In India, the status of this division is as yet uncertain as a joint venture is proposed.

Processed foods is as yet a very small business for HLL. Largely unstudied there are varying estimates about the extent of the market. It is a thrust area for HLL. As of now, 54 per cent of the turnover is contributed by non-cyclical though mature businesses of HLL. The present thrust areas ie foods, beverages and ice creams constitute a small portion of the turnover. The product mix of HLL would therefore take some changing. This limits the exposure that the company has on cyclical businesses. And it is this factor which lends a high degree of certainty to HLL's expected earnings in the next two years.

The latest move

The impending merger of the last Unilever subsidiary Ponds (India) has finally come about. The foundation of this merger was laid in 1993 when HLL and Ponds had moved towards an integrated distribution network, management pool and technology base. This move was largely responsible for fueling Ponds growth over the ensuing years. In 1995, the company achieved sales of Rs 317.13 crore and a net profit of Rs 37.35 crore which rose to Rs 469.7 crore and Rs 61.11 crore respectively in December 1997. HLLs marketing setup was largely responsible for this growth. Since then the question has been, not whether the two companies will be merged but when. Lets look at what this could mean to HLL.

The two businesses have synergies and after the merger, HLL will enjoy better economies of scale. Both depend significantly on the same line of business -- personal care for their income. Personal care products account for 55 per cent of Pond's turnover against 11 per cent for HLL. The personal care business which comprises of hair care, oral care and skin care are the fastest growing businesses for both HLL and PIL.

For HLL the personal care business contributed Rs 884 crore to the turnover. Another factor that could have led to the merger taking place is that HLL expects to double its sales every four years and net profit ever three years. This target itself calls for the two Unilever subsidiaries to merge. Heres why, soaps and detergents the major contributor to HLLs turnover which accounted for 43 per cent of the turnover in 1997 has grown at around 15 per cent as compared to the 47 per cent growth for the personal care business. The soaps and detergents business grew 8 per cent in volumes as compared to a two per cent growth for the overall market. Thus HLL increased its market share despite intense competition from local and international players. However, soaps and detergents is a volume-driven market. This business can only give steady returns and not high margins. So, achieving high growth from this sector will be difficult in the future. The merger with Ponds will enable HLL to achieve its projected earnings growth.

Personal care provides high volumes and high margins. To further understand how the merger of Ponds will benefit HLL lets look at the products, business and market competitive position of Ponds as it stands today.

Over the last five years Ponds has launched a spate of new products in the mass and advanced skin care, face wash and deodorant segments. In a business which is projected to record a sales growth of over 30 per cent over the next three to five years, The product range of Pond's will be enhanced tremendously after the merger. Strong growth in this segment as mentioned earlier will not only raise the contribution of sales from the personal care segment but will also improve profitability.

Coming to Pond's products and competitiveness; the talcum powder and skin care products range primarly makes up the personal products business of Ponds. While talcum powder is the single largest product category, the skin care segment is its fastest growing category. The talcum powder segment comprises 30 per cent of the turnover. Pond's has gained market share over the past few years by largely focusing on the rural market as the urban market is saturated. With the rural market estimated to account for about 25 per cent of sales, Pond's is pushing efforts in this market. Talcum powder has a market penetration of 35 per cent in India. Ponds has upgraded packaging and has also launched an extension of its leading brand Ponds Dreamflower. Ponds is estimated to have a market share of around 60 per cent in the talcum powder market.

Pond's skin care business was previously dominated by the cold cream segment. Ponds has increased the growth potential of this business by launching a host of new products and has expanded the category with regular launches. Over the last three years, it has launched brands in the face wash, moisturiser and body lotion categories. Bhatia expects this category to expand rapidly over the next three to five years with volume growth expected to remain over 30 per cent.

Pond's has added another business which is expected to grow rapidly. Its deodorant business is gaining market share fast currently estimated at Rs 30 crore. This segment is expected to expand to Rs 100 crore by the year 2000. The company has launched two brands Rexona Deodorant and Ponds All Day Long. It commands an 80-per cent market share and is the first local player in the market.

This is only the potential of the Ponds business. Add to this, HLLs own presence and market leadership in various segments and it is ensured that the combined force will be able to take on any competitor domestic or foreign (see table combined force). According to Giridhar Iyengar, assistant vice president (research), ABN Amro Asia Equities (India) "This merger is not about size alone, it will also flow HLL's funds into the aggresive development of Pond's new products." Completeing the pie is Lakme (See box: The vanishing cream). HLL has acquired Lakme's 50 per cent stake in Lakme Lever Ltd. gaining total control of this company. In addition to this, it is also acquiring Lakme's cosmetic brands. With this HLL will own the largest colour cosmetic franchise in the country giving it an unassailable position in the industry.

Hitherto a soaps and detergent company HLL in consonance with its parent Unilevers strategy is gradually transforming into a foods company. This business however, requires substantial investment in brand building, establishing a distribution network including a cold chain. The earlier logic for merging BBLIL was to use the surplus cash generated by HLL to invest in BBILL's food business. HLL intends to focus on ice cream, culinary products and popular foods. These businesses are not expected to make profits immediately. Though the ice cream business may break even in 1999 the company may defer this as it intends to further strenghten its brands. The company plans to invest Rs 80 crore in the ice cream business for organic growth. The merger will again provide a kind of support as Ponds itself is a cash rich company adding to HLLs muscle.

The shareholders

The shareholders of HLL could not have asked for anything better. This move will give HLL a turnover in excess of Rs 10,000 crore in the current year making it the largest company in the private sector. The merged entity would command a market capitalisation in excess of Rs 30,000 crore and a 18 per cent weigthage on the BSE-Sensex.

However, what is in it for the Ponds shareholder? While the jury is still out to determine the swap ratio, various estimates have been put forth. The general consesus is that the Ponds shareholder will receive 80 shares of HLL for ever 100 held in Ponds. But then some expect it to be the the other way around. These are some of the factors that could sway the ratio either ways. It could favour Ponds as HLL needs the companys business to achieve a superior growth, but then it is said that as Ponds has achieved this growth largely because of HLL's distribution network the swap will favour HLL. Whichever way it turns out, both the shareholders will gain as they will own a

company that can only achieve higher growth in the future.

At current levels most analysts recommend a buy on the HLL scrip. The downside potential from the current levels is minimal. Moreover, HLL is one of the most liquid counters and a favourite of domestic and foreign institutional investors.